The thing that annoys me most about Republicans' new-foundopposition to the $50bn orderly liquidation fund is that they are, without question, doing Wall Street's bidding on this.

Killing a "pre-funded" resolution fund — which would be used to help pay for resolutions under the new resolution authority — is the Street's #1 issue in financial reform. That might seem a bit strange at first, until you realize that the majority of the $50 billion would come directly out of the major dealer banks' profits over the next few years. (Never underestimate the Street's ability to be short-sighted.) This issue has been at the top of the Street's wish list since last summer, when Barney Frank started suggesting that the House bill might include a pre-funded resolution fund.

The funny thing is, the Street had been having a very hard time getting traction on this issue. They lost the battle over pre-funding in the House, whose financial reform bill did end up including a "Systemic Dissolution Fund" (the size of which was left to the FDIC's discretion, which means it definitely would be larger than $50bn). They were also having a hard time getting any traction in the Senate — Dodd wanted a pre-funded resolution fund, the administration had signed off on pre-funding, and Warner and Corker appeared to have agreed on a $50bn resolution fund as part of their compromise on the resolution authority.

Enter Mitch McConnell. As soon as McConnell started loudly calling the $50bn pre-funded resolution fund a "bailout fund," and made opposition to it a Republican litmus test, everyone started distancing themselves from the idea. And now a pre-funded resolution fund is all but dead. Amazing.

Now, I think it's pretty clear from my record that I'm about as far from being a Wall Street/Washington conspiracy theorist as you can get. But in this case, what I honestly believe happened is that when McConnell and John Cornyn had their infamous meeting with a group of Wall Street executives a couple weeks ago, McConnell and Cornyn asked what their #1 issue in financial reform was, and after being told it was pre-funding the resolution authority, McConnell and Cornyn basically promised to kill it. It was, after all, a fundraising meeting, and McConnell and Cornyn are desperate to raise money for November.

The Street's problem, apparently, was that it had been trying to make the case for a post-funded resolution authority on the merits. McConnell didn't want to deal with all that "logic" hocus-pocus, so he decided to just start straight-up lying about the resolution fund. And it worked. Ah, politics.

(To be fair, there's a reasonable case to be made on both sides of this issue. With a pre-funded resolution fund, you lose the ability to tailor financial institutions' respective contributions to the fund based on how much they benefited from the resolution of a large bank, or how culpable they were in causing the bank to fail. For instance, with a post-funded resolution fund, we could make JP Morgan and Citi pay for a larger share of the cost of Lehman's failure, based on the conclusions in the Examiner's Report. Pre-funding obviously forces the banks to internalize the costs upfront, but it sacrifices the ability to tailor the costs of a bank failure.)

So it turns out that Blanche Lincoln's derivatives bill (pdf) is a bizarre mix of solid and utterly insane. The bill understandably punts on what is far and away the most important issue in derivatives reform: the scope of the clearing requirement, which is left to the discretion of the CFTC. That's to be expected, and probably the best way to go. The bill does set up a pretty good process for deciding which instruments will be required to clear, which will most commonly involve the CFTC reviewing an instrument that a clearinghouse decides to list and make available for clearing, and determining whether or not to make clearing mandatory for that instrument.

The insane parts, however, are breathtakingly irresponsible. The "no bailout" provision (Section 106) would cut off the top 100+ US commercial banks, plus all the major dealer banks, from the Fed's discount window. That's insanity. I trust I don't have to explain why even introducing a bill with this kind of nonsense in it is so dangerous. If you want to know why Sen. Lincoln's bill is spooking the markets, look no further. It's not because the bill is "strong" — and, by the way, it doesn't even have an exchange-trading requirement, so you can't blame that. It's because the bill would hang most of the banking system out to dry by cutting them off from a central bank backstop, and if enacted, would seriously risk a run on the capital markets. This kind of bullshit has to go — the entire section needs to be deleted, forthwith.

Another crazy provision is Section 120, which would impose a fiduciary duty on swap dealers when entering into a swap with any pension fund, endowment, or retirement fund, as well as any governmental entity (federal, state, or local). This represents a phenomenal misunderstanding of how duties at the various levels of the market operate. ERISA already imposes a fiduciary duty on pension fund managers, trustees, etc., who then, as highly-paid professionals with a fiduciary duty, are empowered to deal at arms-length with dealers. Whether broker-dealers should owe a fiduciary duty when giving advice is a legitimate question, but it's also a completely separate question that has no place in a derivatives bill. Moreover, Lincoln's bill goes way beyond the issue of broker-dealers giving advice, instead requiring dealers to act as fiduciaries (to fund managers who are already acting as fiduciaries) whenever they even enter into a swap with a pension fund, endowment, governmental entity, etc. Look, market-makers are intermediaries; they can't owe a fiduciary duty to both sides. If you want to protect pensioners, then enforce the already existing fiduciary duties pensioners are owed.

These aren't the only bad provisions in Blanche Lincoln's bill (there are a few more), but they're by far the two most dangerous and destructive provisions. If we could strip the crazy out of Lincoln's bill, then it would honestly be a solid foundation. But let's first focus on stripping the crazy out.

The expectation is that if derivatives move onto a more transparent, competitive market, fees for financial firms will go down, which should be good for end users. But the end users have been very worried about derivatives reform. [Goes through various theories of why end-users are opposed to mandatory central clearing.]
...
Those theories make some sense. I'd also like to hear what Economics of Contempt thinks of this issue.

Ask and ye shall receive! To be honest, I really don't care about the end-user exemption issue — and that's the point. The end-user exemption is almost by definition a sideshow, and it's truly bizarre that certain progressives have decided to make this is a Huge Battleground in derivatives reform. So while part of me doesn't care whether progressives make killing any end-user exemption a priority, another part of me doesn't want to see progressives make this another one of their "litmus tests" for OTC derivatives reform, because you know what? They're wrong.

What you have to understand is that OTC derivatives reform divides the universe of swap users into four categories:

The only people we're talking about exempting from the clearing requirement are the commercial end-users, and even then only when they're hedging commercial risk (a superfluous limitation if you ask me, but whatever).

The overriding reason we're moving standardized/liquid derivatives onto clearinghouses is to mitigate the systemic risk posed by purely OTC derivatives markets — in other words, to make sure the market can handle the failure of a single counterparty. But commercial end-users by definition aren't big enough users of swaps to pose a systemic risk. If a company that would otherwise be a commercial end-user is a big enough player in the swaps market that its failure would pose a systemic risk, then it will be classified as a MSP, not a commercial end-user. Moreover, all swaps, cleared and uncleared, will have to be reported to a registered swap data repository, which the CFTC will have full access to. This allows the CFTC to monitor swaps users on an ongoing basis, so if a company that's originally classified as a commercial end-user ramps up its swaps use too much, the CFTC can reclassify it as a MSP. As long as all the major swaps users are required to use clearinghouses, then who cares if commercial end-users are exempt?

So why are commercial end-users so opposed to mandatory central clearing? It depends. I've seen some end-users who are concerned about telegraphing their business decisions (i.e., acquisitions for which they need to pre-hedge). But by far the biggest reason is that central clearing would tie up way too much of their cash. Clearinghouses require counterparties to collateralize their exposures by posting daily variation margin, which means that commercial end-users would have to post cash collateral based on the day-to-day fluctuations in swaps prices. Given the generally higher level of volatility in the swaps markets, this has the real potential to tie up a significant amount of commercial end-users' cash. This is a legitimate concern, and there's no serious policy reason why we shouldn't have any end-user exemption at all.

Like I said, though, I don't really care about the end-user exemption issue. The percentage of derivatives falling under the end-user exemption depends, of course, on which derivatives are ultimately subject to the clearing requirement, but we're really only talking about, at most, ~5% of swaps. The main reason is that the majority of OTC derivatives that will be forced onto clearinghouses will be interest-rate derivatives (e.g., IR swaps, caps, floors), and the biggest end-users of IR derivatives are commercial banks and other financial institutions — that is, MSPs and non-MSP financial institutions.

So not only is the end-user exemption a sideshow, but it's also a sideshow that doesn't make policy sense to oppose.

I'm still not sure if I want to write a full post about the Goldman charges, because (a) I don't have the offering docs, and (b) it's pretty clear that people are going to believe whatever they want to believe, facts/law be damned. But reading over the SEC's complaint yesterday, I was stunned by how weak their case is. Unless the SEC is holding back an absolute smoking gun, which is unlikely, Goldman is going to knock this weak shit out of the park. As to the merits, again, I don't want to get into it without the offering docs, but let me just say one thing: everyone keeps saying that Paulson had "significant influence" over the composition of the portfolio, as if that phrase means something. It doesn't. (Disclosure: John Maynard Keynes had a significant influence on my thinking.)

The debate inside Goldman right now is over whether to settle quickly, or take it all the way to judgment. I'm betting they take it to judgment. They probably could've settled with the SEC already, given how long ago they received the Wells notice. My guess is that the SEC was demanding too high a settlement, and that Goldman balked, wagering that the SEC wouldn't bring such a ridiculously weak case. Whoops. If I were there, I'd tell them to just settle, but then again, I was always the one saying we should settle. (I'd have advised settling after the Wells notice came, if only to prevent that "Fabulous Fab" email from ever seeing the light of day. If that's not worth a billion dollars, then what is?)

My sense is that they're thinking, "You know what? The know-nothing talking heads can get all huffy if they want, but we're right, and they're wrong, and we've had just about enough of this shit. We're taking it all the way!" [Cue the rah-rah blast emails.] While I kind of sympathize with that view (emphasis on "kind of"), I also think it's incredibly short-sighted. Sure, having attention-hungry idiots constantly villify you in the media eventually gets to you, but it's still just words. This is the first time all that nonsense has turned concrete and hurt Goldman monetarily, not the culmination of some long series of events which has forced them to draw a line in the sand. So take a deep breath, and realize that this can either be a one-month story that you lose, or a two-year story that guarantees a steady stream of negative publicity and wears on morale, but that you win. Take the blue pill.

(I wrote this post a while ago, but for some reason I never got around to publishing it. I was reminded of it when I read Felix Salmon's post on derivatives reform from this morning, in which Felix gives a quick-and-dirty explanation of clearing vs. exchange-trading. I was going to write a take-down of Bob Litan's recent Brookings paper on derivatives reform, but it's honestly not even worth my time. Litan makes a compelling case for derivatives reform in a derivatives market that simply does not exist. The number of basic factual errors is overwhelming, and if Litan advocates for a reform you also endorse, it's likely by coincidence. Suffice to say, you rely on it at your own risk.)

Repeat after me: a clearing requirement and an exchange-trading requirement are NOT the same thing. They are very, very different. It is extremely important that people understand the difference between mandatory clearing and mandatory exchange-trading, because there's an incredible amount of confusion about this in the press — even journalists who cover financial reform constantly conflate clearing and exchange-trading.

A clearing requirement is a requirement that all eligible derivatives be cleared on a central clearinghouse (also known as a central counterparty, or CCP). A clearinghouse provides critical counterparty risk mitigation by mutualizing the losses from a clearing member's failure, netting clearing members' trades out every day, and requiring that parties post collateral every day. Clearinghouses also centralize trade reporting, and can provide any level of post-trade transparency to the OTC derivatives markets that your heart desires — same-day trade reporting, including prices, aggregate and counterparty-level position data, etc. Virtually all of the harmful opacity and murkiness of the current OTC derivatives markets can be ended with just a clearing requirement — that is, a clearing requirement is a prerequisite for getting rid of the harmful opacity in OTC derivatives; an exchange-trading requirement is not.

In sum, virtually all of the systemic risk mitigation in derivatives reform — reduced counterparty risk, the huge increase in transparency, the reduced complexity, regulatory access to the necessary data, etc. — comes from the clearing requirement.

An exchange-trading requirement, on the other hand, is simply a requirement that all eligible derivatives use a particular type of trade execution venue: exchanges (also known as "boards of trade"). It is important to remember that an exchange-trading requirement has nothing to do with clearing — they are completely separate issues. People tend to think of exchanges as synonymous with clearinghouses because, at least in the US, the big exchanges own their own "captive clearinghouses," so most exchange-traded derivatives are also cleared through the exchange's clearinghouse. But they are two separate functions entirely.

The exchange is just the trade execution venue (think NYSE vs. Nasdaq). The only thing that an exchange-trading requirement adds to the clearing requirement is "pre-trade price transparency." That's it. As I've explained before, pre-trade price transparency is not always and everywhere a good thing — and if mandated for all cleared derivatives, it would almost certainly be a bad thing on net. Mandating a particular form of trade execution venue (of which there are many, and among which the competition is fierce) for all cleared derivatives is incredibly short-sighted, and just bad policy.

But even if you accept the most optimistic view of the exchange-trading requirement, the benefit we're talking about is reducing the bid-ask spread that hedge funds and bond managers pay on OTC derivatives from 0.8 bps to 0.4 bps, or from 10 bps to 5 bps. This is what progressives are fighting for? Not knowingly, of course, but they've clearly been fooled into believing that the exchange-trading requirement is the same as the clearing requirement (something they actually should fight for). Arguing that exchange-trading would be a better deal for end-users is NOT an argument for why public policy should require exchange-trading; it's just your view on the relative merits of the various trade execution platforms — a view which most other end-users obviously do not share. There's absolutely no reason that we need to settle these disputes by legislation. It's also important to remember that not including an exchange-trading requirement would do nothing to prevent the market from migrating onto exchanges.

The ultimate difference, then, between the clearing requirement and an exchange-trading requirement is this:

The clearing requirement is what's important, and the fight over the scope of the clearing requirement is where ALL the action is in derivatives reform;

The exchange-trading requirement, on the other hand, is a pretty terrible idea, which even under the most optimistic assumptions would provide only minimal benefits to financial markets — it is, in other words, an extremely dangerous sideshow.

Washington Post editorials have long been a goldmine for unintentional comedy, so I wasn't at all surprised to see an editorial bemoaning that "partisan politics is getting in the way" of derivatives reform. How is partisan politics making it into something as pure as the derivatives reform debate? Why, it's the White House's doing, of course!

Now the White House, convinced that it has a winning issue -- go ahead, Republicans, side with Wall Street if you dare -- is discouraging Democratic senators from working with any Republicans who might still be so inclined. The risk is that the mudfight will keep Congress from doing the essential business: bringing most of the derivatives market into the sunlight.

I immediately clicked on the link the Post provided, because I'm pretty close to the derivatives reform debate, and I hadn't heard anything about the White House discouraging Senate Dems from working with Republicans (which would be a big deal). The linked article, however, says absolutely nothing about the White House discouraging Senate Dems from working with Republicans. In fact, the article disproves the editorial's bogus claim about the White House. Here's what the article says about the negotiations between Blanche Lincoln and Saxby Chambliss on a bipartisan derivatives bill:

Administration officials, who are being kept abreast of the talks between Lincoln and Chambliss, said they are trying to ensure that the two lawmakers do not increase the scope of those exceptions and create loopholes that financial firms could exploit. One senior administration official, who spoke on the condition of anonymity, acknowledged that the bill may be more friendly to business interests that are close to the agricultural committee.

The official said the administration would be open to compromise on the issue if it hastened bipartisan consensus and helped move the regulatory reform legislation forward in the Senate. In addition, the Obama administration is trying to head off possible turf battles between regulators who would share oversight of derivatives.

Memo to Washington Post editorial board: When a "senior administration official" tells one of your reporters that the White House would be "open to compromise on [derivatives] if it hastened bipartisan consensus," that's called encouraging Senate Dems to work with Republicans on derivatives reform.

What's actually going on here is that the Post is carrying Saxby Chambliss's water: not surprisingly, the editorial appeared mere hours after Chambliss released a statement saying that his negotiations with Lincoln have broken down, and blaming the White House for "forc[ing] politics in the pathway of meaningful financial regulatory reform" — without, of course, specifying anything the White House did that was partisan. But I guess Chambliss didn't need to provide evidence, since the Post's editorial board is clearly happy to make up the facts for him.

(Oh yeah, and the Post's mobile site is still so terrible that it's practically unusable. Ironic, seeing as ~99% of the Post's target audience is glued to a Blackberry. Just thought I'd throw that in there.)

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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